IPhone's Crutch of Subsidies

By

Anton Troianovski

February 27, 2012

BARCELONA—For Google Inc., Europe's economic turmoil has had a silver lining: Smartphones that use the Internet giant's software are crushing the iPhone in countries hard hit by the continent's debt crisis.

Last year, despite Apple Inc.'s high-profile launch of the new iPhone 4S, only 5% of the smartphones sold in Greece and 9% of those sold in Portugal were iPhones, according to research firm IDC. Most of the rest were phones running Google's Android operating system, which the company is promoting heavily as it seeks a firmer foothold in the wireless industry.

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The results point to a rare weak spot for Apple—its heavy reliance on subsidies from wireless carriers to make its iPhones affordable to a wider range of consumers. The practice has proved to be a big advantage for Apple, which posted a 73% jump in revenue in its latest quarter, at the expense of carriers such as Sprint Nextel Corp., which started carrying the iPhone last fall but doesn't expect to make a profit on the device until 2015.

In countries like the U.S. and the U.K., carrier subsidies helped the iPhone win more than 20% of the smartphone market last year. But its performance in parts of southern Europe where most consumers don't sign contracts and have to pay full freight for phones suggests Apple's position could suffer if carriers tire of underwriting most of the cost of the devices, as some are in countries such as Denmark and Spain.

"Smartphone penetration and adoption is being helped by the entry of lower-price devices, which basically are Android devices," said Carlos Alberto Silva, a spokesman for Portuguese carrier Optimus.

Android phones that cost less than $200 without a contract are widely available in Europe, helping Google undercut the much more expensive iPhone. In Portugal, at wireless carrier Vodafone Group PLC, the cheapest Apple phone—an eight-gigabyte version of the older-model iPhone 4—sells for $680, according to the carrier's website. Phones running Android can be had for as little as $106, and even Samsung Electronics Co.'s high-end Galaxy S II is cheaper than the cheapest iPhone.

In markets like the U.S., where consumers generally pay $200 or $300 for smartphones regardless of the brand, price isn't as much of a factor. The reverse is true in Greece, Portugal, and elsewhere, where carriers don't subsidize most smartphones.

At Greece's largest wireless carrier, Cosmote Mobile Telecommunications SA, the most popular smartphone sold last year was Samsung's Galaxy Mini, said Dimitris Koutsonas, head of mobile data and services. The price: $188 without a contract. "In this economic situation, we had to push the low-end smartphone," Mr. Koutsonas said.

As a result, more than 60% of the smartphones sold by Cosmote last year were Android phones, Mr. Koutsonas said.

The success of Android helps Google to ensure that its search engine—its most important source of revenue—as well as mapping and other services, are preloaded on mobile devices, through which consumers are spending more time online.

Google licenses Android to hardware manufacturers essentially free, doesn't get a cut of device sales and takes only a small share of revenue generated from app sales for Android devices.

The software company hopes the wider range of prices for Android phones boosts their adoption—and helps the operating system gain traction with carriers wary of subsidies and customers leery of contracts.

"Our competitors are much more dependent on such subsidies," said John Lagerling, Google's director of Android partnerships. "From a sustainability standpoint, if you have very expensive devices as the only ones available to access your ecosystem, then that can come with a pretty severe hangover in the long run."

In the U.S., carriers pay Apple an estimated $400 every time a customer buys an iPhone with a two-year contract, analysts say. Sprint has acknowledged that iPhone subsidies run 40% higher than they do for other smartphones on average. The goal is to make it easy to buy the phone then make the money back and a profit over time on service contracts. Contract-free "prepaid" carriers, on the other hand, leave consumers to pay the full price of a phone.

Wall Street has grilled Apple on its strategy for prepaid carriers, even as the company sold a record 37 million iPhones in its most recent quarter, more than double the year-earlier tally. The company has kept a nearly three-year-old model, the iPhone 3GS, on the market to appeal to budget-minded buyers, including prepaid users. But the 3GS still sells for $535 without a contract at Greece's Cosmote.

Apple Chief Executive Tim Cook told analysts in January that it "was too early to tell" how the lower-priced versions would perform in the prepaid market over time but that the company was "thrilled" with iPhones sales as a whole.

At an investor conference this month, Mr. Cook added that emerging markets, which often use the prepaid model, are "critical" for the company, but that each country is different and some may evolve over time. "I don't really subscribe to the premise that a prepaid market is a prepaid market is a prepaid market," he said. Apple, he said, had persuaded China Unicom to try a contract and subsidies approach in addition to its prepaid one, and that it had performed well.

"You can bet that we are into details in every single country in the world trying to learn what we can to adjust, maybe to do better into the future," Mr. Cook said.

The debate over device subsidies is part of a tug of war between mobile operators, Internet companies and phone makers seeking control and profits in the wireless industry. All three camps are gathering in Barcelona this week for an annual industry conference.

Carriers around the world are having second thoughts about subsidizing phones, presenting a risk for all phone makers—not just Apple. That became clear in Denmark last year after several leading wireless carriers stopped subsidizing phones and lowered their monthly rates to keep up with lower-priced competitors. "We saw that the customers valued lower prices on calling plans, and simpler calling plans, higher than the subsidy on the phone," said Jon Erik Haug, CEO of the Denmark unit of Oslo-based wireless operator Telenor ASA.

In the second half of last year, after Danish carriers stopped offering subsidies, phone sales declined about 10% from the second half of 2010, according to IDC analyst Francisco Jeronimo. Smartphone sales continued to grow, but at a much lower rate than in 2010.

In Spain, telecom giant Telefónica SA also is having doubts. "We can't keep subsidies at these levels," José Miguel Gilpérez, CEO of Telefónica Spain, recently told Spanish newspaper El País. "When you buy a TV or any other consumer good, you pay for it. It is healthier that users pay for their devices and operators invest in networks and services."

For phone makers, any change by carriers could have an impact on the sales of high-end devices.

In the U.S., where contract plans and phone subsidies dominate, IDC says that around 90% of smartphone shipments over the past four years were for devices that cost more than $300—despite the recession and uncertain recovery. In Italy, where prepaid plans dominate, that proportion was 67% last year, and in crisis-hit Greece and Portugal, only about 40% of the smartphones shipped in 2011 cost more than $300.

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